One recent suggestion to prevent contagion among troubled banking institutions has been the concept of banks preparing “living wills” - a basic plan of how a bank could be pulled apart without damaging the broader industry.

Professor Kevin Davis, Research Director at the Australian Centre for Financial Studies at University of Melbourne explains the concept.

What do living wills mean for banks?

One of the things that came out of the global financial crisis was general recognition that the powers of the regulators to resolve a troubled financial institution are not as good as they should be, so that when large banks get into difficulty we find there are all sorts of problems in them making a smooth and graceful exit from the industry.

Reinforce balance sheets: Jean-Claude Trichet.AAP

So part of the attention of regulators around the world has been to try to find ways to improve that whole process. That involves looking ahead and saying, if an institution gets into trouble, what’s involved in helping it exit the industry in a way that doesn’t disrupt the financial system and also makes life easier for customers?

The notion of living wills relates to the fact that regulators are planning to require large institutions to develop a “book” they can take off the shelf that would say if we get into trouble, here are the issues that will have to be worked out in terms of pulling the institutions apart and possibly transferring its business to other institutions.

Why isn’t there something like this in place already?

I think these things aren’t in place because people tend to work on the assumption that you are going to live forever.

Financial institutions and companies in general typically operate on the principle that they are going to survive and be profitable and should they get into a situation where there is a risk of trading when insolvent, then standard bankruptcy or insolvency procedures would come into play, with administrators or receivers appointed.

We do have those resolution mechanisms in place, but they don’t work well in the case of financial institutions where there are large amounts of outstanding creditors to repay. So resolution becomes a lot more messy.

Also, these large organisations are operating across borders and there are very significant problems in trying to develop resolution procedures across countries that fit together well.

In Australia, we recently passed legislation that adopted the UN’s model guidelines for resolution of international institutions.

If a subsidiary operating in Australia fails, it would normally be administered by a local entity and liquidation would proceed under Australian court rules.

Under the new legislation, if there is an insolvency process going on for a parent, then Australian arrangements would be subsumed under those more general insolvency arrangements.

In the case of banks, we have situations where there are large amounts of obligations to domestic creditors where it becomes a lot more complicated.

And how will banks respond?

It’s a complex task and a very big ask of management. But on the other hand, for bank boards it’s probably a very good process to go through in the context of actually understanding more about the nature of their institutions, the inter-relationships between various parts of it and the things that could go wrong and what you might do to prevent things going wrong. And importantly, how you could act quickly when things do go wrong and head it off at the pass.

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So could this ensure we don’t see a repeat of the spectacular bank crashes we saw in 2008?

You may still get spectacular collapses but one would hope that regulators in particular will be able to step in much more quickly in conjunction with the managers of the bank and effectively organise things such as a transfer of business, by being able to identify which bits of the business can be separated and sold off or merged into some other viable entity and which bits need to be wound down.

And in a sense, that is really one of the critical issues. In a bank failure, there will generally be some good and bad parts of the bank. You want to be able to separate those bits out in such a way that you can keep the good bits going without too much disruption to the economy, but manage the bad bit out of the industry.

The main benefit is that you have this living will and that you never have to execute it, so the main process is one of discovery about potential risks and issues.

Troubled bank Dexia passed a stress test just three months ago. Could living wills help here?

A living will would tell you what to do when you don’t pass a real live stress test. Any stress test involves a set of hypothetical assumptions about what scenario you are choosing to test them against and you won’t always pick the one that happens. There are lots of cases where stresses could arise - such as after Lehman Brothers when international capital markets froze up - and one of the real issues in banking is that organisations that are essentially viable and solvent suddenly find a liquidity crisis hits and funding dries up.

They then become forced to make a fire sale of assets and it then creates a situation where selling assets at depressed market prices puts them into insolvency, which is of course not what you want.

Trying to ensure there is adequate liquidity and government support in appropriate ways that convinces the market that they needn’t run on this bank, is very important.